Corporate FX Hedging in Evolving African Markets
By Bulelwa Soyamba, Principal Structured FX Sales – ABSA CIB
Unprecedented economic shifts in global markets have created uncertainty across the board, fuelling currency volatility particularly in emerging market economies. As a result African currencies tend to take the brunt the most, when compared to that of developed countries. Recently, major global central banks, such as the US Fed and ECB, have turned significantly more dovish, indicating their preparedness to ease monetary policy in the face of weaker economic growth. The implication is that, if global growth slows materially, commodity prices may follow suit. Consequently, emerging market economies, in particular Sub-Saharan Africa, with high exposure and dependency on commodity exports tend to be hammered the most. Given that most African economies have very fragile economic fundamentals, weak growth and fiscal risks egregiously high could hinder their ability to benefit from the currently on-going global rate cutting cycle.
These economic disparities are not entirely on the back of shifts in supply and demand dynamics across the continent, but are largely driven by economic structural makeup, liquidity constraints, heightened political risks and restrictive regulatory environments just to name a few.
Corporate FX hedging in our African economies often encounters considerable pitfalls due to largely unpredictable dry liquidity spells when compared to more developed countries. Although in recent years there may have been slight improvements in some parts when hedging FX exposure, global corporates with African footprint still feel the brunt and inherent costs of liquidity shortages. Whilst the South African rand may be considered high beta currency with minor liquidity constraints, large local multinationals remain subject to cash flow uncertainties when transacting across the borders.
Perfectly ideal market conditions would make it simple for a corporate to obtain local or foreign funding while allowing it to manage foreign currency exposure effectively. However, the reality is that transparency in developing markets can be quite opaque, because banks as well as corporates tend to be uncertain about volumes that go through the market and the actual rates being quoted and in periods of high volatility this culminates in thinner liquidity and triggers panic. Secondly, due to the unbalanced nature of some of these economies, the demand from importers tends to exceed that of exporters, implying that the market is often one sided. To smooth out this asymmetry, some of the African central banks intervene at the cost of holding reserves. Another issue is that onshore banks tend to have small limits approved by the regulator and this makes it difficult if not impossible to absorb fairly large corporate flows. This inability to absorb liquidity shocks causes increased currency volatility.
When comparing apples with apples, Uganda stands out as being one of the most open and stable economies in the continent, while Kenya, South Africa and the like are heavily regulated to varying degrees. Governments are now becoming acutely aware of keeping a stable currency (independently from the regulator) and mostly try to give investors comfort that there is sufficient liquidity to invest and divest. On the other hand, Ghana has increasingly shown good support for key sectors as well as investors, while its neighbour Nigeria aims to follow suit.
While African central banks’ roles may also include stabilising the domestic currency, reducing USD speculation and dollarisation in their economies, this can come at the expense of liquidity, volatility and market inclusion. To sketch a picture, Kenya to some extent imposes funding restrictions on offshore entities by preventing short-term funding that is less than a year, making it hard in certain instances for corporates to hedge some of their undesired exposure. On the other hand, restrictive exchange controls in Nigeria require corporates to obtain a certificate of capital importation before they can purchase US dollars in the market with the aim of preventing capital flight, dollarisation and currency speculation.
However, onerous administrative processes tend to discourage investments. Some central banks such as in Mozambique do not permit corporates to participate in the forward market with the aim of reducing speculative FX transactions, limiting corporates to only hedge on demand in the spot market. These imposed restrictions expose corporates to heightened FX risks due to volatile swings in the exchange rates. The South African Reserve Bank has somewhat looser foreign exchange restrictions for corporates when compared to the rest of the continent; however, there are still complex regulatory and documentary requirements associated with moving money out of the country. Mauritius, on the other hand, is considered an attractive tax haven for multinationals with business interest across the African continent as it allows companies to avoid some of the regulatory hurdles.
Alternative FX hedging solutions
South African treasurers in recent years have become more sophisticated than ever before, and have mostly shown openness to explore more efficient ways to manage FX risks by taking a more balanced FX exposure management approach. However, corporates with presence in other African nations hardly consider managing FX exposure using any alternative FX hedging instruments other than spot and forward contracts. Alternative FX hedging instruments such as FX options can provide cheaper and efficient ways to manage the FX risks, but the regulatory restrictions often make it impossible for corporates to participate.
Hedge accounting standards
As treasurers begin to consider hedging FX exposure using FX options, a majority soon run into the difficult problem of whether or not these alternative FX instruments meet the hedge accounting standard requirements of IAS 39. Their concerns are often driven by the fact that most corporates’ hedging policies still limit FX hedging to instruments that meet hedge accounting requirements of IAS 39. However, at the beginning of 2018, a new hedge accounting standard IFRS 9 was made effective in South Africa. The requirements of this new hedge accounting standard make it possible for corporates to optimise their FX risk management strategies. The standard places greater emphasis on use of FX derivative instruments, which means that corporates now have flexibility to use a variety of FX hedging instruments including FX options, and makes it possible for treasurers to account for these transactions when reporting financial results.